Volatility

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The yield in the 10-year bond is creeping up to 3% as bonds continue to sell off. It would seem, based on bond prices, that the taper is getting priced into the bond market. Perhaps investors believe that the inflation bubble is mounting and would rather just find safer store value. Maybe they have come to terms with the equity markets being a better investment. I am sure it is a combination of all three, what is interesting is that the Federal Reserve (taper or not) is still the largest buyer (between 70 and 90%) of all gross new issuance of bonds. The moving higher of the bond market yield trickles down to mortgage rates, which are also tricking higher. I am sure, in the current economic environment, there is a ceiling at which the Federal Reserve will do their best to halt any further rise. The next few weeks will certainly be volatile and I suspect we could soon see a floor on bond prices.


Volatility

We frequently hear the term volatility in relation to the financial markets, but what does it mean? Without getting technical, there are two forms of volatility, actual volatility (how much and how big a financial product moves) and theoretical volatility (the expectations of movement). When we hear the generic volatility term being used by journalists in the media, it is usually referred to with a negative connotation and an expectation of a big move lower. It is a little bothersome, but not necessarily completely wrong. They are just trying to communicate their concern about more downside risk in the market, but they are not very articulate about it.

VIX - Silexx
VIX courtesy of Silexx.com

Volatility doesn’t know the difference between going up or down, it just is a measure of how much and/or how fast it moves. The VIX is the most widely watched indicator of the current volatility in the market. The VIX is an index that prices in a weighted average of option premiums in the S&P 500 index. The basic idea is that options premiums increase as volatility increases (a bigger expectation of a move in the S&P index). The problem with using the VIX as a risk gauge in the market is that at its extremes it is usually wrong. When the VIX is in the 25+ range the market has already made a huge move (usually a crashing or melt-down move) and when the VIX is in the sub 13 range, the market is usually just going up and fear has left the market.


premium calculator

Insurance Premiums

It is important at this point to understand that option premiums (and the VIX) are generated by order-flow in the market (buyers and sellers) and thus it is nothing more than the general market’s consensus of volatility based on how options are priced. It certainly doesn’t mean it is correct; it is just what the market is willing to buy or sell current options prices at, as measured in volatility. Ok, this is getting confusing so let me bring some real-world analysis in to play and it might make sense. Think of the VIX like an insurance premium. Premiums on insurance (health, flood, hurricane, and auto) are based on an expectation of risk. The higher the risk, the higher the premium; the lower the perceived risk, the lower the premium. The problem is that if there is not a hurricane for years, premiums usually fall because the perceived risk has diminished and demand declines as buyers are not willing to pay for the higher premiums. Furthermore, the price of your premiums is not based on just your risk, but the risk pool of all they insure.


Hidden Volatilty

doolittle_-_pintos
(Bev Doolittle’s painting – hidden horses – how many do you see? A quick look and many one or none. You need to pay attention!)

So we have two measures of volatility; what the market has actually done and the theoretical expectations (such as the VIX). However, I would argue there is a third measure of volatility and it is not exactly quantified with current measures of volatility. I call this “Hidden Volatility”, which measures the pent up volatility that the market is not currently experiencing and the VIX is ignoring. Just like the insurance premiums based on the risk pool, the market forces, and a host of other factors, it is not an accurate predictor of an individual event or individual’s risk. As we have seen insurance companies get hurt when a huge surprise storm hits.

The market has these expected volatile events such as elections, earnings, interest rate changes, etc. What it doesn’t expect and doesn’t not price correctly is single unknown events like a take-over, merger, or news event. That is when the VIX is wrong (sometimes very wrong). However, the “hidden volatility” I am referring to is something different. It is when the market under-prices market risk. Perhaps, since it is driven by market forces (buyers and sellers) it can easily get priced incorrectly relative to the actual risk of market movement.


Hey I can store Energy !

Stored Energy – Spring

When I think of “hidden volatility” I think of elastic potential energy, like the energy stored in a coiled spring. We can’t see it, we are not experiencing it, but we KNOW it is there. When the spring is released the energy unleashed can be violent and even uncontrolled.

When the market had recently moved higher and the S&P 500 (SPX) moved to 1680 and stayed there for weeks, as we saw the VIX drop (options premiums decrease), I could see in my mind’s eye the spring being depressed and coiled. The elastic potential energy was building and the amount of energy required to keep that spring coiled was weakening. At some point it would not be able to hold back the spring’s energy any longer. That is what happened last Thursday and the market made a large move, more than the VIX had predicted and larger than even current volatility. In fact, you could see the VIX play catch-up and quickly, as it moved from 11.5 to 14.5 (over a 25% move). The VIX was wrong, very wrong.

So how do we know when the VIX is incorrectly pricing market volatility? Well, some of it is just experience and I think even the average investor can make a rudimentary observation to realize that something is just too cheap. I usually comment when I think it is too low, or those instances when it gets too high. We can even observe some possible predictors of forthcoming hidden volatility. For instance, we have a big politically based September with the possible taper announcement, new Federal Reserve Chairman announcement, debt ceiling debate getting underway, and host of other political battles that will certainly bring forth volatility. Is the VIX currently under or over pricing these events, or is it pricing the risk correctly? As investors we can use this information to hedge our long positions, take a bearish stance, or look to add yield. It is this information that should help shape your strategy decisions.

I have been working on a quantitative model for measuring hidden volatility, but that remains in the works for now.


Support & Resistance

INDU 15,000
The Dow Jones is sitting right at this level and the next drop will be down to 14,800 and then 14,600. For now we could be in for a little consolidation around 15,000.

NDX 3050
We all await Apple’s iPhone release and any other announcements on September 10th. This is event could make or break this index. Apple is at 500 and I would expect some resistance, but we could continue to run higher into the September 10th announcement. If we run up too much into the release date, we could be facing a strong sell-off if they disappoint.

SPX 1650
Like the Dow Jones, I suspect a little consolidation at this level. The VIX will probably stay between 14 and 15.

RUT 1020
I am also watching the RUT very closely to see if we get some consolidation at these levels. Remember, the RUT is the best broad-based indicator of order flow.


If the market falls to the next level of supports and remains under pressure into the month of September, in this case we could see the VIX over-price risk, perhaps move up to 20+. Then we could get into an oversold situation quickly and be in for a big surprise. Imagine if the market sells off further and then the Federal Reserve states they will NOT taper and keep the current QE program in place for now. That could create a huge bounce in the equity and bond market, sending the 10-year yield back down towards 2%.

If they do taper, I think it would be so small that it could put a floor into the market and a solid support level.

The other big, unknown and potentially volatile event is the decision of who will be the next Federal Reserve Chairman. I suspect we will hear the announcement this September that it will be Janet Yellen. As a huge Dove (far left of Bernanke) and in praise of current Japanese monetary policy, I would suspect that any thoughts of tapering would end. This announcement will certainly bring some volatility to the market as many will be uncertain of her leadership and policy style. However, for those that have followed her career, the expectations are pro-stimulus, pro-QE, pro-Keynesian, and even one that supports a more active role of the Federal Reserve in policy (based on her past speeches). This could bring a renew lift to the equity markets and also further build the inflation bubble and also the the bond bubble.

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